The Economy
Now the longest since the Great Depression, the recession that officially began in the fourth quarter of 2007 significantly deepened and spread globally in the last six months. In the fourth quarter of 2008 the economy shrank 6.3% on an annualized basis, and consensus forecasts look for at least a 5% annualized decline in the quarter just ended. Few credible observers foresee the return of positive growth before the end of the year, and many expect it not until early or mid-2010. Chance Gardiner, in Jerzy Kosinski’s novel and wonderful movie, Being There, famously said, “There will be growth in the spring.” This time, alas, that would have to be next spring.
That does not mean that signs of macroeconomic bottoming out are not discernible. Indeed, the newest business cliché appears to be “green shoots,” as in the tell-tale data points whose rise portends better days ahead. For example, the price of copper, a crucial industrial commodity, has risen considerably and so has the “Baltic Dry index,” a measure of shipping volume and demand. Also, just as we know that the sudden freezing of the credit markets last fall precipitated the contraction quantified above, some harbingers of their melting can be seen. For example, rates on 30-year “conforming” home mortgages have fallen to a record low, and the crucial “TED spread” (the difference between very short-term interbank lending—LIBOR—and very short-term government borrowing—T-bills) has dropped to pre-crisis levels. Yet unemployment continues to rise (up to 8.5%) and house prices collapse (down 29% from their peak).
These “green shoots” in some respect are a direct result of the policy initiatives undertaken late in the Bush administration and, to a much greater degree, by its Obama successor. A veritable alphabet soup of programs has been launched both to stimulate the broader economy and to unlock the banking system. It is inappropriate here to debate the merits or demerits of these initiatives, but suffice it to say that economic history teaches us that they should be big, quick and clear. Otherwise, we as a nation along with the rest of the world risk following the Japanese of the 1990s into a “lost decade.” Yes, there are those on the libertarian right who, like Hoover and Mellon, stand for laissez faire and call for a return to the gold standard just as there are those on the loony left who demand nationalization of the banks and call for putting the miscreant bankers in stocks (the wooden kind). To the undersigned, the middle way looks a lot more promising.
At bottom, an extraordinary irony is at work and in our favor—namely, the dollar’s role as a reserve currency. Thus, the financial crisis was spawned by years of ever-growing macroeconomic imbalances such as our yawning current account deficit and our debt-financed overconsumption, as has been described many times in these pages. Truly, we have been as profligate as the Romans. In the modern world, any other country would be severely punished for its profligacy. Remember, for example, Latin America in several episodes in the last several decades or Asia a decade ago. In those and many more cases, their betters—i.e., American officials and bankers—would arrive to administer harsh medicine, typically including very painful currency devaluation.
In this case, however, the U.S. dollar remains the sole reserve currency in the world, and while our chief international creditors, the Chinese, have indicated some displeasure of late at the terms of trade thus imposed on them, it remains unlikely that the dollar will go the way of Sterling in the ‘50s. Essentially, we can still print as much of the stuff as we want and at worst have to worry only about inflation some years hence. Of course, we indeed should worry about inflation.
Alas, history has another lesson to teach Americans, one remarkably consistent across a long period of time and true for both banana republics and lordly hegemons. And that is that after a major recession or depression precipitated by a financial crisis, it generally takes the economy four to six years to regain its prior peak. For Americans, whose disposable income has been static for many years while income disparity rose to heights not seen since a previous gilded age, this could well test their tolerance. In other words, the anger provoked by the AIG bonus fiasco could be a foretaste of much worse to come.
The Stock Market
The sickening slide that stock prices exhibited in the latter part of 2008 was redeemed in part by a bearmarket rally that recovered a bit more than 20% of the lost ground by early 2009. Unfortunately, all that and a bit more was lost in the first quarter as the market broke through the November lows in early March. Then, in a Great Tease, it quickly retraced itself in what one would like to believe is the beginning of a new bull market but is likely to disappoint again. One reason is that the stock market, though a so-called leading indicator, is unlikely to build a sustained advance until, based on historical norms, about six months before an economic recovery. As explained above, it is unlikely that this happy day will arrive before the end of the year and quite possibly well into the next. Another reason is that while the market suffered a precipitous decline, by some measures it never reached the kind of nadir associated with secular bear markets, including those following a financial crisis. Snapshot measures of valuation like current price-earnings multiples and dividend yields are essentially useless in this environment, when, for example, corporate earnings have been crushed and dividends are being slashed. Longer-term measures of valuation, however, like cyclicallyadjusted and after-inflation price-earnings multiples show that stocks are now fairly valued but even at the recent lows were never truly cheap. It simply has to be recognized that there remains some significant chance of another leg down. Finally, it has to be said that history shows that after a financial crisis, stocks take much longer to regain lost ground than after the typical business-cycle bear market. What is known as mean reversion can take three to six years as opposed to the more common one and a half years. In other words, we may be in for a long slog.
Coda
While ideologues continue to debate the causes and cures of the financial crisis as suggested above, more thoughtful observers have generally forged a consensus view. They see the seeds of our common destruction as deriving from undue reliance on complexity in the naïve belief that mathematics held the key to risk control. In other words, beyond increasing human understanding of complex systems like the capital markets, mathematics could be used to manipulate them for profit and systematically so. Their bosses might not have understood the extremely opaque methods adopted by the “quants” whom they hired, but facing the extraordinarily generous compensation systems that stood to reward them in the very short run, they had little reason to try.
Indeed, the fundamental problem was that they used tools that worked well in other contexts to shape probabilities but applied them to an arena—the movement of security prices—where they really would not hold. The familiar example is the Gaussian normal distribution as represented by the bell curve. It may well depict the outcomes from, say, coin flipping, but it ignores significant outliers or so-called “fat tails” in the capital markets. It can be used by smart people to make, say, small amounts of money for a considerable amount of time and with remarkable consistency, but it does not eliminate the chance of disaster.1 In other words, capital markets are human institutions, not clockworks, so at the end of the day are as vulnerable to human fallibility as those who believe that they are immune to emotion and unreason. Homo economicus never lived.
The relevant institutional background is that commercial banks for years lost market share in
commercial lending to the capital markets and even the so-called shadow banking system
(securitization, hedge funds, etc.). Investment banks saw their traditional lines of business (such as acting as underwriter or broker-dealer) dwindle. In recent years, deregulation meant both sets of institutions were significantly less constrained in terms of leverage. In both cases, there was also a very dangerous misalignment of interests as between their managers and their shareholders due to traditional compensation schemes. The result was inevitable: as one observer put it, “’Fat tails’ proved the downfall of the fat cats,” not to mention the rest of us.
Jerome W. Anderson
April 8, 2009 |
